IRS Publication 575: Pension and Annuity Income

IRS Publication 575 provides guidance for taxpayers receiving payments from pensions and annuities, detailing how to report this income for tax purposes. This publication covers income from various sources, including employer pension plans, 401(k)s, and Individual Retirement Arrangements (IRAs). Pension and annuity income refers to a series of payments made at regular intervals over more than one full year. The tax treatment of these payments depends on several factors, which the publication helps taxpayers navigate.

Determining the Taxability of Payments

The initial step in handling pension or annuity income is to determine whether the payments you receive are fully or partially taxable. If your plan was funded entirely with pre-tax contributions, meaning neither you nor your employer paid tax on the money when it was contributed, then your distributions are fully taxable.

A distribution may be only partially taxable if you have “cost” in the contract. This cost, also known as the investment in the contract, represents the total amount of after-tax contributions you made to the plan. Since these are funds on which you have already paid income tax, you will not be taxed on them again when they are distributed.

When you begin receiving payments, a portion of each payment is considered a tax-free return of your cost. The remaining portion, which represents earnings and pre-tax employer contributions, is the taxable amount. The payer of your pension or annuity should be able to provide you with information regarding your cost in the plan.

Calculating the Taxable Portion

Once you establish that your pension or annuity is partially taxable, you must calculate the specific taxable amount. For most recipients of payments from qualified plans, such as 401(k)s, the IRS requires the use of the Simplified Method. This method uses a worksheet found directly within IRS Publication 575 to determine the tax-free portion of each monthly payment.

To use the Simplified Method, you need to know your total cost in the contract and the expected number of payments. The cost is the total of your after-tax contributions, and the number of expected payments is determined using an IRS table based on your age when payments begin. For example, if you are the sole annuitant and your payments start when you are age 61 through 65, the table specifies 260 expected monthly payments. You divide your total cost in the contract by the number of expected monthly payments to find the tax-free portion of each monthly payment. You continue to exclude this portion from your income each month until you have recovered your entire cost.

While the Simplified Method is common, some situations require the use of the General Rule. This rule applies to nonqualified plans, such as a commercial annuity you purchase directly from an insurance company. The General Rule is more complex and often requires the use of actuarial tables to determine life expectancy and the expected return on the contract, so taxpayers using it may need assistance from a tax professional.

Understanding Rollovers

A rollover is the process of moving money from one retirement account to another, such as from a 401(k) to an IRA. The advantage of a rollover is tax deferral; it allows you to postpone paying income tax on the distribution until you withdraw the funds from the new plan, preserving the tax-deferred status of your savings.

There are two main ways to execute a rollover: a direct rollover and an indirect rollover. In a direct rollover, the financial institution holding your retirement funds transfers the payment directly to another plan or IRA, and no taxes are withheld. An indirect rollover occurs when the distribution is paid directly to you, and you have 60 days to deposit the funds into another eligible retirement plan to keep the distribution tax-free.

A complication with indirect rollovers is that your plan administrator is required to withhold 20% of the taxable amount for federal income tax. To complete a full rollover and avoid tax on the withheld amount, you must use your own funds to make up for the 20% that was withheld. Failing to complete an indirect rollover within the 60-day period makes the entire distribution taxable. If you are under age 59½, you may also be subject to a 10% early withdrawal penalty. Required minimum distributions (RMDs) and hardship distributions cannot be rolled over.

Special Rules for Lump-Sum Distributions

Certain situations allow for special tax treatment of lump-sum distributions from qualified retirement plans. A payment must meet specific criteria to qualify, including the distribution of the participant’s entire balance from the plan within a single tax year. The distribution must be made on account of the employee’s death, attainment of age 59½, or separation from service.

For individuals born before January 2, 1936, two special tax treatments may be available. One option is the 10-year tax option, which allows the taxpayer to calculate the tax on the lump-sum distribution as if it were paid over 10 years, using the tax rates that were in effect for 1986. Another potential treatment is the capital gain option, which applies to the portion of the distribution attributable to plan participation before 1974, allowing it to be treated as a long-term capital gain.

These special tax treatments are elected by filing Form 4972, Tax on Lump-Sum Distributions. The rules governing these options are complex and apply to a very specific group of taxpayers, as most individuals receiving distributions today will not be eligible.

Reporting Pension and Annuity Income

After determining the taxability of your pension, the final step is to report the income correctly on your tax return. The information you need is provided by the payer on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This form details the total amount of the distribution and indicates how much of it is considered taxable.

When you receive Form 1099-R, you should review several boxes. Box 1 shows the gross distribution, which is the total amount you received. Box 2a shows the taxable amount of the distribution. If the taxable amount was not determined, the “Taxable amount not determined” box in 2b will be checked, and you will need to calculate the taxable portion yourself. Box 7 contains a distribution code that tells the IRS the nature of the distribution, such as a normal distribution, an early distribution, or a rollover.

You will use the information from Form 1099-R to complete your Form 1040, U.S. Individual Income Tax Return. The total pension or annuity distribution is reported on line 5a of the Form 1040, and the taxable portion is reported on line 5b.